Friday, October 14, 2011

A country becomes a financial center because it has succeeded in becoming the trade center.

Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money.

Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.

China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. When the bubble is big enough, China will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

2011-09-12 / Andy Xie

Summary

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China must effectively internationalize its surplus capital for the global economy and its own to function normally. Otherwise, the global economy would suffer bubbles and financial crisis again and again. It may lead to the rise of protectionism that would destroy the global economy.

Irresponsible borrowing by Southern European governments and Anglo-Saxon households and money hoarding by Germany, oil exporters, and East Asian manufacturing exporters planted the seeds for the current crisis. China's share among surplus countries is rising. If China keeps recycling its surplus into government bonds, the resulting distortion would hurt itself and others. The country could become the focal point in the international blame game.

Globalizing China's surplus labor has led to its economy rising over twentyfold in nominal dollar value and becoming the largest trading economy in just two decades. Globalizing the country's surplus capital would make China the largest economy in the world and the biggest financial center in another two. This action is in China and the world's best interest.

The first step in internationalizing China's surplus savings should be to start the international board of the country's stock market. It is a small downpayment but may produce a large effect on the global economy through inspiring multinational companies to expand production. As the global economy double-dips, this action would be China's contribution to supporting the global economy.

As the second largest economy, the largest trading nation with the largest trade surplus, China must take significant responsibility for the healthy functioning of the global economy. Its foreign assets of $4 trillion are overwhelming in government bonds. This lopsided allocation has created huge distortion in the relative price between bonds and stocks. This distortion is a destabilizing factor for the global economy. It should be remedied as soon as possible.

From labor surplus to capital surplus

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Globalizing China's surplus labor is the single most important factor in China's economic development over the past two decades. The surplus depressed China's labor cost to less than 5% of that in the developed economies two decades ago. But, China's labor quality was several times higher than the relative wage suggested. Opening up the country to FDI and building supporting infrastructure led to rapid export growth and industrialization. China has become so successful that it is now the largest trading nation and the second largest economy in the world.

The labor surplus is clearly gone. Indeed, the shortage of blue-collar labor is plaguing many industries. The wage for blue collar labor is rising at a double digit rate. In some industries like mining, it has doubled in the past three years. The wage level, however, is still one tenth of that in the developed economies. Cost isn't a barrier to China's industrialization yet. Upgrading is the right response to the labor shortage. In particular China must compete against Germany and Japan in the coming decade.

As China's surplus labor becomes fully integrated into the global economy, the country has migrated from capital shortage to surplus. China's trade surplus is at $200-400 per capita. This level is relatively low by East Asian standard. It could rise by five times or more. But, because China is so much bigger than other East Asian countries, if its trade surplus per capital reaches that level, the aggregate surplus would be huge relative to the global economy.

For example, if China's trade surplus reaches $1,000 per capita, a modest amount by East Asia standard, the total would reach $1.4 trillion, bigger than all the fund raisings in the stock market in the whole world. How this amount of money is deployed will hugely affect the global economy.

From trade to finance

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A country becomes a financial center because it has succeeded in becoming the trade center. London became the global financial center because the UK had overtaken other countries to be the largest in trading goods and services. The financial center moved to New York because the US replaced the UK as the top player in international trade. China is now the largest trading nation in the world. By 2020 China could dwarf anyone else in international trade, becoming twice as largest as the second largest. Could and should China become the global financial center? The answer to both is yes, I believe. If China doesn't take actions to do so, it would hurt itself and the global economy.

Finance followed trade because most of financial services were related to trade. And, profits were mostly derived from trade too. One could see the linkage by visiting Pingyao, the little town in Shanxi that dominated China's finance in the 19th century. It is a small and poor place bordering Mongolia. In the 19th century, the rise of the Russian Empire created a big market and a safe pathway for selling Chinese goods to it. The people in Pingyao had the advantage of bordering both worlds and could arbitrage the price difference between China and Russia. The profits from the trade and the need for trade finance turned Pingyao into a financial center. It later declined because the seabourn trade replaced the costly overland trade. China's financial center also migrated to Shanghai.

This story repeats on a large scale in the whole world. The United States didn't plot to supplant the UK to become the international financial center. It happened because the US replaced the UK as the biggest industrial power and trading nation. Finance just followed. The importance of the Wall Street is a consequence of the US's industrial success.

The most important economic development in the 21st century is China becoming the largest industrial nation. I have anticipated this for a long time. This is a consequence of globalization and China's cultural characteristics. The government has adopted supportive policies, i.e., not standing in the way. No other country is yet on the horizon to stop China's industrialization.

By one measurement-the industrial energy consumption China is already the biggest industrial economy in the world. The dollar value isn't there yet because Chinese goods are still cheap. China could raise prices to absorb the rising labor cost in this decade and still grow exports at above 10% per annum. By 2020 China could become twice as big as Germany in international trade.

The largest trading nation should become the global financial center. Some may argue that was in the past. Information technology has made where asset trading occurs irrelevant. Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money. Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.

China has avoided Germany's fate by sending its surplus capital into government bonds, especially the US treasuries. This 'all eggs-in-one basket' strategy has worked so far. The government bonds of the major economies have held up in value, even though their economies are in shambles. But, government bonds cannot sustain value if the underlying economies are in constant crisis. At some point, either the government debt level is too high or its tax revenue is too low. Their central banks would be forced to bail out their governments by printing money. China would get its money back, but in severely depreciated currencies. Unless China changes its strategy, it cannot avoid Germany's fate.

China's net foreign assets have risen by twice as fast as its trade surplus. The main reason is capital inflow, especially from overseas Chinese, to avoid a depreciating dollar. The Chinese government is essentially taking on the currency risk for the whole overseas Chinese community. If China loses its foreign exchane reserves, the government may become bankrupt, and the country's financial foundation is gone.

In addition to asset safety, China's 'all eggs-in-one basket strategy' is creating distortion in the global economy. The sharp divergence between stock and bond prices is mostly due to the concentration of money among institutions that just buy government bonds. China is part of the picture. The oil export countries have even more money in the market. The low price of stocks discourages companies to invest and hire workers. While this isn't the only factor, it is a significant one in causing the instability in the global economy.

If a country makes a lot of money, it must be responsible for allocating the money effectively and efficiently to help the global economy. Otherwise, it would be worse off for everyone. In the past decade, China is just one player among several that have amassed money but done a poor job in allocating it. In the next decade, China would dwarf anyone else in amassing money. But, if China couldn't allocate the money effectively, the whole world would blame China for their ills.

If China upgrades its industries successfully in response to its rising labor cost, as Japan did in the 1970s and Korea and Taiwan did in the 1990s, the country may increase its trade surplus to $1 trillion. The per capita level would still be a modest $715 by East Asia standard. The total, however, is above the total fund raisings in all the stock markets in the world. Unless the money is deployed efficiently, i.e., improving rather than impeding global growth, the global backlash would impede China's development, causing disasters for everyone.

An alternative to the trade surplus is running a massive asset bubble to exaggerate domestic demand. Japan did that in the 1980s. China is doing quite a bit now. Without the domestic asset bubble, China's trade surplus would be twice as big, I believe. Running a bubble just delays the inevitable and creates a financial crisis as the price. China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. The bubble can be bigger, twice as big, if the government tolerates it. When the bubble is big enough, the country will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.

The international board is a downpayment

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China has a highly developed manufacturing sector but a backward financial sector. The later is dominated by state ownership and caged by a closed capital account and a fixed exchange rate. The mismatch between the two is the source of so many problems in China. The pressing issue is that the global economy cannot wait for China to go about its own pace. Unless China could allocate its surplus capital effectively and efficiently into the global economy soon, a global backlash against China's development is likely to emerge.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

The multinational companies need to expand in emerging economies. Their home countries don't have money surplus anymore. It makes sense for them to raise money in emerging economies for investments in them. While the market may start small, it would boost confidence among MNC's for future financing. They may become more willing to invest.

China should lay down the rules for the global top 500 hundred companies all to list in China. It should be a transparent process that won't require the aspiring companies to lobby the government individually. If the process is too tightly controlled, it won't have the impact on business confidence.

Many argue that the international board will weigh down the A-share market. This is just a petty excuse. The A-share market is already very low, because it is concerned about the growth at home and abroad. The international board will help the global economy. It would be good for China's economy too. The A-share market may rally on improving confidence.

To boost demand for stocks, the government could introduce new sources of demand. A 401K like retirement plan, for example, could boost stock demand greatly, possibly by over Rmb100 billion per annum. That would be sufficient to offset the fund raisings in the international board. Raising the stock investment ratio for insurance companies would be another source of demand. In short, there are many ways to increase demand to offset the fund needs of the international board. China runs a large trade surplus. Liquidity shouldn't be a problem. Appropriate policy adjustments can keep the liquidity for stock market.

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